We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
Contact the Author: accruedint at gmail.com

Enter your search termsSubmit search form

Web

accruedint.blogspot.com

Friday, May 15, 2009

I've been notably absent in expressing my outrage over how the Obama Administration treated Chrysler's secured debt holders. Let it be known I'm sufficiently outraged on the inside, but resigned on the outside. We should all take it as a lesson: you simply never know what the government might do. The more they tighten their grip, the less I want to invest in any company which has taken government money. Especially in the investment-grade bond market, where, generally speaking, the potential for appreciation is limited.

This brings us to the municipal bond market. In Berkshire Hathaway's 2008 letter to shareholders, Warren Buffett had this to say about the municipal insurance business (the section starts on page 13 if you want the total context). Hat tip to downwithcapitalism who, despite his evil galatic moniker inspired this post.

"A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial."

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors. And the type of behavior Buffett warned of hasn't been evident with Jefferson County, where the overwhelming majority of outstanding bonds are insured. In fact, I'd bet that the insurers have better lawyers and other workout specialists at their disposal compared to what any ad-hoc group of bond holders could put together.

In addition, notice Buffett says "imagine all the city's bonds had been insured... by Berkshire." This isn't the case in reality. Any large issuer is going to have a mixture of insured bonds with various monolines. Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak.

Still, we've seen the precedent set by Chrysler. I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.

Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

So I sure hope this isn't the direction we head. The long-term consequences would be devastating. You'd like to think the Administration has the sense to consider the long-term impact of their decisions, and wouldn't kill municipal bond holders. But then that's what I said about letting Lehman go bankrupt...

7 comments:

It's a fascinating post. I think it's worth looking at the optics, though. Municipal bond holders will attract a fair amount more sympathy than the assortment of mega-banks and hedge funds that supported the Chrysler buy-out. Not that the Chrysler creditor antics helped things, either. The monolines, though, as you mention, would be a huge complicating factor, and if we were talking monolines versus widows and orphans it would be fine, but the monolines aren't there to hold the bag. My guess is that local government, and its employees, would end up holding the bag. The muni market, rightly or wrongly, still has a public reputation straight out of It's a Wonderful Life.

I guess that I am less resigned and more depressed. A sitting president just stole Chrysler from its rightful owners and gave half of it to one of his biggest supporters (the UAW). I'm not really mad anymore. I'm just depressed.

I think you're misreading the Chrysler situation (as it applies to municipals). Obama's gambit worked with Chrysler because the secured bondholders didn't really have a leg to stand on - they were getting more than they would have gotten in a liquidation and certainly more than what Chrysler's assets were worth to Fiat (the only known buyer) *without the union on board*.

Perhaps it would have been better to separate the bankruptcy and the new union contract with Fiat (and, from what I gather, that would have been perfectly possible), but I'm not going to shed any tears about how the process played out since, so far, it looks to me like things have worked out far better than anyone had a right to expect.

Now consider the situation of a municipal issuer with general taxing authority. The game is completely different there.

Specifically:1. A municipal's taxing authority is *very* valuable, so there are real assets for bondholders to go after (liens on future tax payments, for example?). And given that taxation formulas and patterns change relatively slowly, getting a good (and substantial) lower-bound estimate of that value shouldn't be hard.

2. People don't buy and sell cities, so there won't be the complications and constraints that were created by needing to sell something viable to Fiat quickly and cleanly, to maximize the value recovered by a bankrupt Chrysler. Even when a city is in trouble, people can't pack up and move overnight (the way they can stop buying cars), so there's more time to let a bankruptcy play out before doing anything irrevocable.

3. Municipals (unlike Chrysler which is being absorbed into Fiat) don't disappear after a bankruptcy, so they care about their post-bankruptcy reputation. That will influence the treatment of bondholders versus other stakeholders.

Rav basically made all of my points, so I only really have one remaining. Recall that Chrysler's ownership structure was skewed with the private equity leverage employed. I have nothing at all against private equity, but I am not going to cry when one of their investments goes bad, they go hat in hand to the government, and the government exacts a pound of flesh. Also, note to distressed bond funds, distressed bonds are risky!

I think we can all also agree that whatever else the episode says, Nardelli has proven that he does not have the golden touch. I still think he had the right strategy with the HD, Hughes Supply arrangement, but it definitely was not the golden touch…

Lastly, if I recall correctly John Snow, a thoroughly worthless Treasury Secretary, chaired the fund that bought Chrysler and so there is some poetic justice there if he failed there as well as in government.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.